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Lee Kelly in a recent guest post here on The Market Monetarist discussed the implication of excess demand for money for the development of barter and Free Banking. I found Lee’s discussion extremely interesting and think that it could be interesting to see how monetary disequilibrium actually could work as a catalyst for the development of alternative monetary systems – for example the development of so-called local currencies in Greece.

One of the most interesting developments in recently years in the fields of alternative monetary systems is Bitcoin. I am no expect on Bitcoin and I have certainly not made up my mind about the implications of Bitcoin so I have asked the founder of BitcoinNordic.com Lasse Birk Olesen to do a guest post about Bitcoin. I am happy that Lasse has accepted the challenge.

Started in 2009, the decentralized means of exchange for the internet known as Bitcoin has been gaining traction every year since. With no central institution backing it, with no one knowing whether to classify it as currency or as commodity, and their inherent nature making them hard to regulate, Bitcoin has been the subject of much controversy. This post is a short summary of what I have learned about Bitcoin and serves as an introduction to the concept, its economic properties, and a couple of its potential implications for the financial infrastructure of the world.

How does it work? Consider a special type of e-mail that cannot be copied. This means that when you forward this e-mail to someone else, you must lose it from your own inbox. Now also consider that there exists only a finite amount of these special e-mails, and no one can create more of them. Because of these properties, people have started considering these e-mails as valuable. These unique e-mails are of course called Bitcoins.

Value
As Bitcoins have no physical manifestation and no use besides as a medium of exchange, many economists (some citing Mises’ regression theorem) have predicted their value to be a bubble driven by novelty and hype, just waiting for an inevitable burst.

And the Bitcoin price definitely did experience a bubble in the summer of 2011. Going from 1 USD/BTC to 30 USD/BTC in just 2 months from April to June and then dropping back to 2 USD/BTC in November, most of the Bitcoin critics would probably have bet that the show was over. But over the next couple of months the exchange rate went back to 5 USD/BTC and has remained in that area since.

While the exchange rate is not in itself an indicator of the success of Bitcoin, it is of course an indicator of the market’s expectation of the future success of Bitcoin. If Bitcoin enjoys widespread adoption its exchange rate is bound to rise as demand increases.

But while the Bitcoin critics are right that most historical money such as gold had other uses before they became accepted as money, as Mises’ regression theorem states, this does not mean that it is the only way a viable money can come into existence.

Historical examples of money with no other uses exist. One is the case of large rocks known as rai stones which were used for trade between the islands of Micronesia. The rocks, definitely too large for use as tools, derived their value solely from being a means of exchange. In other words, the only reason to value them was because everyone else did.

Properties as money
And so is the case with Bitcoin. With no institution guaranteeing their value, with no guaranteed exchange rate to traditional currencies, Bitcoins’ value stems only from their use as a means of exchange. But unlike the rai stones, which were difficult to transport, Bitcoins ace almost all of the requirements traditionally set forth for good money:

Scarce: No more than 21 million will ever exist

Divisible: Each of the 21 million can be divided infinitely

Fungible: One Bitcoin is as good as the next

Mobile: Can be sent from New York to Tokyo in 10 seconds for an infinitesimal fee

Durable: Will remain intact as long as anyone uses the system

In addition, Bitcoin is the first electronic cash system being completely decentralized and semi-anonymous. No one needs to know who you pay or how many you own. Adding these properties together gives you a unique money system that the world has not seen before. It streamlines many financial operations, and it can open up entirely new markets that had been impossible until now. This uniqueness is what drives the support of the Bitcoin community and gives each coin value. No other system currently allows you to transfer value to the other side of the world in seconds practically for free and without identifying yourself.

As a store of value, however, Bitcoins are still a very poor money, as the mentions of the exchange rate above shows. But with the existence of liquid exchanges to traditional currencies in multiple countries it retains its use as an international transfer of value. And if Bitcoin sees widespread adoption the exchange rate will become less volatile as market depth increases.

Free banking
The inherently decentralized and semi-anonymous nature of Bitcoin makes it hard to regulate. You cannot punish a violator of your country’s laws if you do not know who he is. And you cannot shut down a system if it doesn’t have a point of attack. Trying to close decentralized networks such as Bitcoin is like cutting off Hydra’s heads: Cut one and two new ones grow as the entertainment industry has already realized in combating file sharing networks.

This means that Bitcoin will potentially enable free banking in Bitcoins even if government regulation doesn’t allow it as banks can keep accounts and transactions hidden.

At the moment, there is little to no banking activity in the Bitcoin economy. Lending is done on a peer-to-peer basis between forum users across the world. Because of the difficulty in assigning credit ratings to internet nicknames, interest rates are naturally high in this very interesting and unregulated developing market.

If Bitcoin adoption grows, we should expect actual banks, with or without government banking licenses, to appear to judge borrowers based on face to face interactions instead of internet forum posts.

A common misconception is that fractional reserve banking is impossible with Bitcoins. But just as fractional reserve banking can be done with gold it can be done with Bitcoins.

Less banking
In addition to new opportunities for free banking, I predict that given a larger adoption of Bitcoin we will also see less private banking. The main reason most people store fiat money in banks is not to get interest on their small amount of savings. They do it to for security and to be able to participate in the electronic economy – that is, to be able to shop online and avoid the need to carry around cash and use credit cards instead.

Bitcoins are incredibly flexible when it comes to storage. They can be stored on any digital or analog medium, encrypted by cryptography stronger than used in online banking, and backed up to an infinite amount of locations. They can even be saved in your brain. If your assets are in Bitcoin you no longer need a bank for safeguarding.

And as they are inherently digital, you don’t need a bank to act as a gateway for you to spend them in the electronic economy. Stored on your smartphone you could carry them to a restaurant and pay the bill using your phone instead of a card.

People having less reasons to store their money in banks will contribute to a higher real interest rate. On the other hand, the deflationary nature of Bitcoin will encourage savings and contribute to a lower interest rate. I cannot predict which will be the dominating effect (note: corrected slightly compared to earlier version).

Bitcoin-enforced contracts
An interesting development is the creation of Bitcoin-enforced contracts. For an example of how this could work consider you bought a car for a small down payment and has agreed to make more payments once a month. With the car being connected to the Bitcoin network, it could check for new payments to the seller’s Bitcoin address every month. If your monthly payment has not arrived the car will refuse to start.

One could also imagine this happening today with a deactivation system remote controlled by the car seller. But what if the seller deactivated your car after you had already made all your payments? With a Bitcoin-enforced contract you don’t need to trust the seller, you only need to trust the Bitcoin network of which everyone can check the source code.

Also, scripts can be embedded into Bitcoin transactions which opens up for even more contractual possibilities. One use of this is for pooling resources towards a common good, i.e. to fund the creation of something with positive externalities.

Say your neighborhood wants to buy an empty lot to turn it into a park. Normally someone will start raising money, but what happens if he doesn’t get enough to actually complete the project? Can you trust him to give you your money back? Instead, you can make your donation to his Bitcoin address with the condition that the money is returned to you if not X amount has been sent by others to the same address before Y date. The Bitcoin network will enforce this without you needing to trust the person accepting the donation or even a third party.

The future
As seen in the above section on contracts, Bitcoin is more than a better means of exchange. People discover new uses for the technology every month.

One can conceive of several threats to Bitcoin’s survival and widespread adoption: Could a flaw in the design be discovered that leaves the system open to counterfeiting? It’s very unlikely since it hasn’t been discovered yet even as there is a large financial incentive to do so. And if it happens, the system allows for large structural repairs while carrying on using the same coins. Will the world find no utility in larger adoption of Bitcoin? Unlikely as the financial infrastructure of today belongs to the pre-internet era. For instance, it shouldn’t take days and cost tens of dollars to move value from Europe to the US or Asia.

Perhaps the biggest threat would be from a technically superior Bitcoin 2 that could replace the current system and leave original Bitcoins worthless. As Bitcoin has the momentum, Bitcoin 2 would need to be vastly improved. And as with anything new, the change will not happen in the blink of an eye. Some will be risk takers and make early investments in Bitcoin 2 while others will stick with the good ol’ familiar Bitcoin for a longer time.

I remain optimistic on behalf of Bitcoin. And it certainly is an incredibly exciting experiment that no matter the outcome will have an impact on the theory of money.

PS Sometimes the debate in the blogosphere becomes less civil – that is unfortunate, but seems to be how it sometimes is. My friend Marcus Nunes is having a bit of a fight with Brad DeLong. See Marcus’ Open letter to DeLong here.

Some of the most clever economists I have encountered are actually not formally educated economists. In fact a number of Nobel Prize winners in Economics are not formally educated economists. One of my big heroes David Friedman is not formally educated as an economist, but to me he is certainly an economist – one of the greatest around. Another example is Gordon Tullock who was trained as a lawyer, but he is certainly an economist – in fact to me Gordon Tullock is one of the most clever economists of his generation and it is a complete mystery to me that he has not yet been awarded the Nobel Prize in Economics. The way I perceive people’s skills as economists has nothing to do with their formal education. To me Economics is not an education. Economics is a state of mind.

Therefore, you can easily be an economist without having a formal education as an economist. As a consequence there are also people who have been able to attain a formal title as an economist without reaching that higher state of mind that a real economist has. I have unfortunately also encountered many of this kind of “economists” – economists by title, but not in mind. Many of these people are unfortunately high ranking policy makers.

Unfortunately many universities around the world today do not educate economists to be economists. They primarily educate them in technical skills – math and econometrics. And they educate them in “soft” skills and on different applied issues. A shocking amount of formally educated economists would not be able to explain comparative advantages or marginal utility to you (don’t get me stated on monetary theory). But they might be able to tell you about VAR, ARCH or GARCH – at best. Many – especially in Europe – are just educated to become government bureaucrats.

So what is the state of mind of an real economist? If you need to have that explained you are not yet an economist, but you might still become one by trying to figuring out what Gordon Tullock and David Friedman have in common. You might also read my favourite book on the topic – James Buchanan’s What Should Economists Do?

PS This post is dedicated to all economists without formal education in economics (I miraculously became a formally educated economist in 1995, but it was not the official curriculum at the University of Copenhagen that made me an real economist – I became that by reading Gordon Tullock and David Friedman and other real economists)

PPS Yes, it is fair enough if you call me a sectarian or a cultist when it comes to Economics as a science.

I have for some time wanted the young and talented Lee Kelly to write a guest post for The Market Monetarist. I am happy that he now has done so. Anybody who follows the market monetarist blogs will be familiar with Lee’s name and his always insightful comments.

So thank you Lee and I hope you in the future will write many more posts for my blog.

Lars Christensen

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Guest post: Nick Rowe, Barter, and Free Banking

By Lee Kelly

Nick Rowe recently wrote about the increasing use of barter and makeshift monies during recessions. The market monetarist explanation for the last recession describes how attempts to engage in mutually beneficial exchange are frustrated by a shortage of money; this suggests that people would seek alternatives–such as barter and makeshift monies – to realise desired transactions. While such incentives would be expected to increase with the severity of the shortage, there are unfortunately too many other factors at play to draw precise quantitative predictions. That said, if there were no increase in barter or even a decrease, then I would tentatively consider the market monetarist explanation falsified, and it would require one heck of a good counterargument for me to reverse that judgement.

Alex Tabarrok has presented some evidence comparing the Great Depression and the recent recession. Evidence that barter and makeshift monies increased during the Great Depression is very strong–market monetarism passes the test. However, evidence regarding the last recession is less conclusive; there are suggestions of an increase in barter and makeshift monetary arrangements but nothing substantial.

Although I wouldn’t have expected anything comparable to the Great Depression, like Tabarrok, I’m surprised at just how weak of an effect appears to have been. My own observations are of a slight increase in barter, and the relative success of Bitcoin during the recession is suggestive, but there is little more than anecdotal evidence to go on for now. The evidence–or lack thereof–presented by Tabarrok should pose an interesting challenge to market monetarists.

In any case, my purpose here is actually to explain a little about the underlying theory of this explanation and how it dovetails with an arguments for free banking. An increasing use of barter and makeshift monies in during a shortage of money takes on a whole different meaning when viewed from the perspective of free market in money and banking. But first, let me try and keep everyone on the same page by clarifying just what is meant by a ‘shortage of money’ or an ‘excess demand for money’?

What is an Shortage or Excess Demand for Money?

The term ‘shortage’ has a precise meaning in economics. A shortage occurs when the market price of some good is below its equilibrium price. In such cases, there are more people willing to buy at the prevailing price than are willing to sell, leaving an excess demand. Holding supply and demand constant, the market normally clears such disequilibria by increasing prices until shortages are eliminated. However, a shortage may persist indefinitely when there is a price ceiling, i.e. an upper limit to some price usually mandated by a government. If the equilibrium price of some good is greater than its price ceiling, then rising prices are unable to entirely eliminate shortages.

Normally, when demand is frustrated by a price ceiling, the excess goes somewhere else. For example, a binding price ceiling on apples would frustrate demand, leaving some people who want to buy apples unable to find willing sellers at the prevailing price. What do people who want apples do instead? Maybe they buy pears, oranges, bananas, or whatever–probably something that serves a similar purpose. In any case, the excess demand for apples spills over into higher demand for other kinds of fruit.

Money is special. All else being equal, an increase in the demand for money is automatically a shortage of money. An excess demand for money cannot be cleared by increasing its price, because money doesn’t have a price of its own. To reach equilibrium, every other price must haphazardly grope its way there by a roundabout path of deflation. A shortage of money is unlike a shortage of anything else, because money is the medium of exchange. An excess demand for apples will probably just result in more spending on other fruit, but an excess demand for money results in less spending altogether. With an insufficient quantity of the medium of exchange to facilitate desired transactions, potential output is sacrificed–this manifests as the temporary lull in economic activity called a recession.

Barter and Makeshift Monies From a Free Banking Perspective

The relation between a shortage of money and barter is similar to the relation between a shortage of cars and cycling. Suppose the government imposes a binding price ceiling on cars and supply is elastic. While there will always be some driving and some cycling, the shortage of cars results in people cycling more than if the supply of and demand for cars were in equilibrium. However, cycling cannot substitute for all journeys that would otherwise be taken by car, and so those journeys simply never happen. Likewise, only a fraction of transactions frustrated by a shortage of money can be completed using substitutes like barter or makeshift monies.

What does this have to do with free banking? In a world where central banks operate an effective monopoly over money, there is only one monetary policy. If the central bank pursues bad monetary policy, then the economy is constantly rocked by surpluses or shortages of money. But what if people had a better alternative than barter or makeshift monies? What if there were multiple competing issuers of money? What if our eggs weren’t all in one basket?

Free banking theory envisions a world where each money issuer has their own “monetary policy”, and a shortage or surplus created by one issuer is a profit opportunity for all others. When attempts to engage in mutually beneficial exchange are frustrated by a shortage of money, then people will seek alternatives. In an ideal free banking scenario, those alternatives are readily available monies created by institutions poised to soak up any excess demand for money. A free banking system is, in this way, robust against errors of monetary policy that can devastate an economy dependent on a central bank.

No system is perfect, and I’m aware of the futility of advocating free banking. However, I’m very much in favour of theorising about free banking. It is often only when ideas are contrasted with alternatives that we tease out hidden assumptions. Insights that seem deep and elusive from one perspective can become trivial and obvious from another.

Normally, economists understand market failure and government intervention in the light of ideal markets, but all such norms are reversed when it comes to money and banking. Many insights that are hard to come with conventional thinking, such as nominal GDP targeting, are relatively straightforward when understood in the light of free banking. The idea that people will seek alternatives to a given money when it’s suffering from a shortage of surplus is not just implicit in free banking, but is at the the core of what it means for there to be monetary competition in the first place.